The Hindu Business Line : Mutual funds can do more for investors

BY ALL accounts, 2005 has been a wonderful year for investors in and managers of mutual funds. There has been a considerable increase in the assets under management of equity funds and profitability has thus increased for fund houses. Investors, too, have never had it so good.

Many of the new mutual funds schemes in which investors poured substantial sums have performed reasonably well. And the new schemes have not been stark under-performers, as in earlier years. They have categorically reinforced the fact that mutual funds remain the most suitable avenue for retail investors to build wealth.

Yet the mutual funds industry remains driven by the kind of marketing initiatives where the interest of the brokers is paramount. There are no debates on what could be done to save investors from the clutches of the brokers or on product development. Visibly, there are no attempts to link product development to feedback from investors and market performance of funds. Inefficient products are left unaddressed, suggesting a lack of research into product performance. Notably, communication about assessment of fund performance is simplistic and consequently, in many cases, misleading.

These may be a consequence of the small size of the industry as of now. As its size improves, investor interests may regain their rightful place. There is, however, reason to believe that the industry structure does not provide scope for developments. The mutual fund industry may be forced to focus on doing simple things, mainly managing index funds better. Innovations that matter may be driven into the fold of private equity unless the incentive structure is re-worked.

Inefficient products: A sore point about mutual funds is that inefficient products are just left to languish. Substantial sums invested in sector funds, index funds, bond funds, balanced funds and monthly income plans are under-performing. We are, however, yet to see the kind of restructuring necessary to make them more suitable to an investor's portfolio.

For instance, indices such as BSE-100 and BSE-200 have consistently outperformed the Sensex and the Nifty by about four percentage points per annum over the past three years. There is, however, no attempt to introduce index funds at least on BSE-100.

The introduction of a BSE-100 Index fund would at least provide investors with the option to switch from under-performing Sensex and Nifty funds. There is no talk of such an index fund now. But there may be when the market is in a bearish phase and investors' risk aversion has increased. It may not make sense then, though.

Another case is Monthly Income Plans. They have been perennial under-performers. Monthly Income Plans have, on average, recorded returns of 9 per cent over the past 12 months. This is below the 10 per cent returns for Crisil MIP Blended Index. The actual under-performance is higher as the Crisil Index is based on Nifty returns.

If you replace Nifty returns with average performance of diversified equity funds, the extent of under-performance would increase substantially. Has anything ever been done to address this issue?

Communication relating to the performing class — diversified equity funds — too is highly simplistic. The answers to questions on what is behind performance — stock selection or higher risk taken by the fund — are unavailable. A dispassionate enquiry into equity fund performance may be beyond fund-houses. They could, however, indicate to investors how much additional risk is taken by the fund-houses, such as that increased investments in mid-cap and small-cap stocks contributed to performance.

Fund of funds is a practically stillborn concept. There is also no attempt to improve the efficiency of balanced funds or market them better. Balanced funds and Fund of Funds should occupy pride of place in a retail investor's portfolio. But that is not the case.

Incentive structure: This is how it looks when you take a snapshot of the mutual fund industry now. But it could change for the better. After all, the mutual fund industry even now controls less than 2 per cent of household assets. The incentive structure for managers could militate against such developments.

Mutual funds take home a flat fee based on volume of assets under management and not on performance. If size of assets increases because of performance, then indirectly fees will also rise. However, if assets desert after performance, the loss to fund managers is heavy. There is nothing in the incentive structure to drive a fund manager to do the best for retail investors.

There is definitely a case for working out a fee structure that pays fund managers a flat fee plus additional compensation for performance over a three or five-year period. Many talented fund managers have already left for the harsh performance-based but lucrative world of private equity investing. It may not take much to retain or regain talented fund managers. Maybe even a mere ten per cent of excess gains over a benchmark would be enough.

Without sharing at least a small part of the gains, mutual fund investors can neither hope for better research nor can they hope to retain the best performing managers. As talent flees, in just 10 years, investors will be forced to seek the safe havens of low-cost index funds. Performing diversified equity funds or balanced funds would become a thing of the past. Enthusiasm of fund-houses would then be sustained only until product launches and only until that product category registers returns. As seasons change, the focus of marketing initiatives will change. Inefficient products will continue to languish as they do now.

The mutual fund industry has been on a good run and, at least as of now, can boast of extremely talented people in its ranks. The status quo is, however, not the recipe for continuing the good show. SEBI, AMFI, fund-houses and investors need to usher in changes that help the Indian mutual fund industry achieve a unique position in the world of investing.

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